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Chapter 1
The foundations of
economics
This chapter is an introduction to the study of economics. It is also an introduction to many topics that will be
explored in depth in later chapters.
1.1 Scarcity, choice and
opportunity cost
The fundamental problem of economics:
scarcity and choice
The problem of scarcity
� Explain that scarcity exists because factors of production
are finite and wants are infinite.
The term ‘economics’ is derived from the ancient Greek
expression oı′kov vε′ μεiv (oikon nemein), which originally
meant ‘one who manages and administers all matters
relating to a household’. Over time, this expression
evolved to mean ‘one who is prudent in the use of
resources’. By extension, economics has come to refer to
the careful management of society’s scarce resources to
avoid waste. Let’s examine this idea more carefully.
Human beings have very many needs and wants.
Some of these are satisfied by physical objects and
others by non-physical activities. All the physical
objects people need and want are called goods (food,
clothing, houses, books, computers, cars, televisions,
refrigerators, and so on); the non-physical activities are
called services (education, health care, entertainment,
travel, banking, insurance and many more).
The study of economics arises because people’s needs
and wants are unlimited, or infinite. Whereas some
individuals may be satisfied with the goods and services
they have or can buy, most would prefer to have more.
They would like to have more and better computers,
cars, educational services, transport services, housing,
recreation, travel, and so on; the list is endless.
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Introduction
Yet it is not possible for societies and the people
within them to produce or buy all the things they
want. Why is this so? It is because there are not
enough resources. Resources are the inputs used to
produce goods and services wanted by people, and for
this reason are also known as factors of production.
They include things like human labour, machines and
factories, and ‘gifts of nature’ like agricultural land
and metals inside the earth. Factors of production do
not exist in unlimited abundance: they are scarce, or
limited and insufficient in relation to unlimited uses
that people have for them.
Scarcity is a very important concept in economics.
It arises whenever there is not enough of something in
relation to the need for it. For example, we could say
that food is scarce in poor countries, or we could say
that clean air is scarce in a polluted city. In economics,
scarcity is especially important in describing a
situation of insufficient factors of production, because
this in turn leads to insufficient goods and services.
Defining scarcity, we can therefore say that:
Scarcity is the situation in which available
resources, or factors of production, are finite,
whereas wants are infinite. There are not enough
resources to produce everything that human beings
need and want.
Why scarcity forces choices to be made
� Explain that as a result of scarcity, choices have
to be made.
The conflict between unlimited wants and scarce
resources has an important consequence. Since
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people cannot have everything they want, they
must make choices. The classic example of a choice
forced on society by resource scarcity is that of ‘guns
or butter’, or more realistically the choice between
producing defence goods (guns, weapons, tanks)
or food: more defence goods mean less food, while
more food means fewer defence goods. Societies
must choose how much of each they want to have.
Note that if there were no resource scarcity, a choice
would not be necessary, since society could produce
as much of each as was desired. But resource scarcity
forces the society to make a choice between available
alternatives. Economics is therefore a study of
choices.
The conflict between unlimited needs and
wants, and scarce resources has a second important
consequence. Since resources are scarce, it is
important to avoid waste in how they are used. If
resources are not used effectively and are wasted,
they will end up producing less; or they may end
up producing goods and services that people do
not really want or need. Economics must try to find
how best to use scarce resources so that waste can
be avoided. Defining economics, we can therefore
say that:
Economics is the study of choices leading to the
best possible use of scarce resources in order to best
satisfy unlimited human needs and wants.
As you can see from this definition of economics,
economists study the world from a social perspective,
with the objective of determining what is in society’s
best interests.
Test your understanding 1.1
1 Think of some of your most important needs
and wants, and then explain whether these are
satisfied by goods or by services.
2 Why is economics a study of choices?
3 Explain the relationship between scarcity
and the need to avoid waste in the use of
resources.
4 Explain why diamonds are far more expensive
than water, even though diamonds are a luxury
while water is a necessity without which we
cannot live.
2 Introduction
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Three basic economic questions: resource
allocation and output/income distribution
� Explain that the three basic economic questions that
must be answered by any economic system are: ‘What to
produce?’, ‘How to produce?’ and ‘For whom to produce?’
� Explain that economics studies the ways in which
resources are allocated to meet needs and wants.
Scarcity forces every economy in the world, regardless of
its form of organisation, to answer three basic questions:
• What to produce. All economies must choose
what particular goods and services and what
quantities of these they wish to produce.
• How to produce. All economies must make
choices on how to use their resources in order to
produce goods and services. Goods and services
can be produced by use of different combinations
of factors of production (for example, relatively
more human labour with fewer machines, or
relatively more machines with less labour), by using
different skill levels of labour, and by using different
technologies.
• For whom to produce. All economies must make
choices about how the goods and services produced
are to be distributed among the population. Should
everyone get an equal amount of these? Should
some people get more than others? Should some
goods and services (such as education and health
care services) be distributed more equally?
The first two of these questions, what to produce and
how to produce, are about resource allocation, while the
third, for whom to produce, is about the distribution of
output and income.
Resource allocation refers to assigning available
resources, or factors of production, to specific uses
chosen among many possible alternatives, and
involves answering the what to produce and how to
produce questions. For example, if a what to produce
choice involves choosing a certain amount of food
and a certain amount of weapons, this means a
decision is made to allocate some resources to the
production of food and some to the production of
weapons. At the same time, a choice must be made
about how to produce: which particular factors of
production and in what quantities (for example, how
much labour, how many machines, what types of
machines, etc.) should be assigned to produce food,
and which and how many to produce weapons.
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If a decision is made to change the amounts of goods
produced, such as more food and fewer weapons, this
involves a reallocation of resources. Sometimes,
societies produce the ‘wrong’ amounts of goods and
services relative to what is socially desirable. For
example, if too many weapons are being produced,
we say there is an overallocation of resources in
production of weapons. If too few socially desirable
goods or services are being produced, such as education
or health care, we say there is an underallocation of
resources to the production of these.
An important part of economics is the study of how
to allocate scarce resources, in other words how to
assign resources to answer the what to produce and
how to produce questions, in order to meet human
needs and wants in the best possible way.
The third basic economic question, for whom to produce,
involves the distribution of output and is concerned with
how much output different individuals or different
groups in the population receive. This question is also
concerned with the distribution of income among
individuals and groups in a population, since the amount
of output people can get depends on how much of it
they can buy, which in turn depends on the amount
of income they have. When the distribution of income
or output changes so that different social groups now
receive more, or less, income and output than previously,
this is referred to as redistribution of income.
Test your understanding 1.2
1 What are the three basic economic questions
that must be addressed by any economy?
2 Explain the relationship between the three
basic economic questions, and the allocation
of resources and the distribution of income or
output.
3 Consider the following, and identify each one
as referring to output/income distribution
or redistribution; or to resource allocation,
reallocation, overallocation or underallocation
(note that there may be more than one answer).
(a) Evidence suggests that over the last two
decades in many countries around the
world the rich are getting richer and the
poor are getting poorer.
(b) In Brazil, the richest 10% of the population
receive 48% of total income.
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(c) Whereas rich countries typically spend
8–12% of their income on providing health
care services to their populations, many poor
countries spend as little as 2–3% of income.
(d) Many developing countries devote a large
proportion of their government budget
funds for education to spending on
university level education, while large parts
of their population remain illiterate.
(e) If countries around the world spent less
on defence, they would be in a position
to expand provision of social services,
including health care and education.
(f) Pharmaceutical companies spend most
of their research funds on developing
medicines to treat diseases common in rich
countries, while ignoring the treatment of
diseases common in poor countries.
Resources as factors of production
We have seen that resources, or all inputs used to
produce goods and services, are also known as factors
of production.
The four factors of production
Economists group factors of production under four
broad categories:
• Land includes all natural resources, including all
agricultural and non-agricultural land, as well as
everything that is under or above the land, such as
minerals, oil reserves, underground water, forests,
rivers and lakes. Natural resources are also called
‘gifts of nature’.
• Labour includes the physical and mental effort
that people contribute to the production of
goods and services. The efforts of a teacher, a
construction worker, an economist, a doctor,
a taxi driver or a plumber all contribute to
producing goods and services, and are all
examples of labour.
• Capital, also known as physical capital, is a man-
made factor of production (it is itself produced)
used to produce goods and services. Examples of
physical capital include machinery, tools, factories,
buildings, road systems, airports, harbours,
electricity generators and telephone supply lines.
Physical capital is also referred to as a capital good
or investment good.
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• Entrepreneurship (management) is a special

human skill possessed by some people, involving
the ability to innovate by developing new ways of
doing things, to take business risks and to seek new
opportunities for opening and running a business.
Entrepreneurship organises the other three factors
of production and takes on the risks of success or
failure of a business.
Other meanings of the term ‘capital’
The term ‘capital’, in a most general sense, refers
to resources that can produce a future stream of
benefits. Thinking of capital along these lines, we can
understand why this term has a variety of different
uses, which although are seemingly unrelated, in fact
all stem from this basic meaning.
• Physical capital, defined above, is one of the
four factors of production consisting of man-made
inputs that provide a stream of future benefits in
the form of the ability to produce greater quantities
of output: physical capital is used to produce more
goods and services in the future.
• Human capital refers to the skills, abilities and
knowledge acquired by people, as well as good
levels of health, all of which make them more
productive. Human capital provides a stream of
future benefits because it increases the amount
of output that can be produced in the future by
people who embody skills, education and good
health.
• Natural capital, also known as environmental
capital, refers to an expanded meaning of the
factor of production ‘land’ (defined above). It
includes everything that is included in land,
plus additional natural resources that occur
naturally in the environment such as the air,
biodiversity, soil quality, the ozone layer, and
the global climate. Natural capital provides a
stream of future benefits because it is necessary to
humankind’s ability to live, survive and produce
in the future.
• Financial capital refers to investments in
financial instruments, like stocks and bonds, or
the funds (money) that are used to buy financial
instruments like stocks and bonds. Financial capital
also provides a stream of future benefits, which take
the form of an income for the holders, or owners, of
the financial instruments.
Test your understanding 1.3
1 (a) Why are resources also called ‘factors
of production’? (b) What are the factors of
production?
2 How does physical capital differ from the other
three factors of production?
3 Why is entrepreneurship considered to be a
factor of production separate from labour?
4 (a) What are the various meanings of the term
‘capital’? (b) What do they all have in common?
Scarcity, choice and opportunity cost: the
economic perspective
� Explain that when an economic choice is made, an
alternative is always foregone.
Opportunity cost
Opportunity cost is defined as the value of the next
best alternative that must be given up or sacrificed in
order to obtain something else.
When a consumer chooses to use her $100 to buy
a pair of shoes, she is also choosing not to use this
money to buy books, or CDs, or anything else; if CDs
are her favourite alternative to shoes, the CDs she
sacrificed (did not buy) are the opportunity cost of the
shoes. When a business chooses to use its resources to
produce hamburgers, it is also choosing not to produce
hotdogs or pizzas, or anything else; if hotdogs are
the preferred alternative, the hotdogs sacrificed (not
produced) are the opportunity cost of the hamburgers.
Note that if the consumer had endless amounts of
money, she could buy everything she wanted and the
shoes would have no opportunity cost. Similarly, if
the business had endless resources, it could produce
hotdogs, pizzas and a lot of other things in addition
to hamburgers, and the hamburgers would have
no opportunity cost. If resources were limitless, no
sacrifices would be necessary, and the opportunity cost
of producing anything would be zero.
The concept of opportunity cost, or the value of
the next best alternative that must be sacrificed to
obtain something else, is central to the economic
perspective of the world, and results from scarcity
that forces choices to be made.

4 Introduction

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Test your understanding 1.4
1 Explain the relationship between scarcity and
choice.
2 Define opportunity cost.
3 Think of three choices you have made today,
and describe the opportunity cost of each one.
The production possibilities model
� Explain that a production possibilities curve (production
possibilities frontier) model may be used to show the
concepts of scarcity, choice, opportunity cost and a
situation of unemployed resources and inefficiency.
The production possibilities model is a simple model
of the economy illustrating some important concepts.
Introducing the production
possibilities curve
Consider a simple hypothetical economy producing
only two goods: microwave ovens and computers.
This economy has a fixed (unchanging) quantity and
quality of resources (factors of production) and a fixed
technology (the method of production is unchanging).
Table 1.1 shows the combinations of the two goods
this economy can produce. Figure 1.1 plots the data of
Table 1.1: the quantity of microwave ovens is plotted
on the vertical axis, and the quantity of computers on
the horizontal axis.
If all the economy’s resources are used to produce
microwave ovens, the economy will produce
40 microwave ovens and 0 computers, shown by point
A. If all resources are used to produce computers, the
economy will produce 33 computers and 0 microwave
ovens; this is point E. All the points on the curve joining
A and E represent other production possibilities where
some of the resources are used to produce microwave
ovens and the rest to produce computers. For example,
at point B there would be production of 35 microwave
ovens and 17 computers; at point C, 26 microwave
ovens and 25 computers, and so on. The line joining
Point Microwave ovens Computers
A 40 0
B 35 17
C 26 25
D 15 31
E 0 33
Table 1.1 Combinations of microwave ovens and computers
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A
40
B
35 G
30
C
microwave ovens
25
20
F
15 D
10
5
E
0
5 10 15 20 25 30 35 40
computers
Figure 1.1 Production possibilities curve
points A and E is known as the production possibilities
curve (PPC) or production possibilities frontier (PPF ).
In order for the economy to produce the greatest
possible output, in other words somewhere on the
PPC, two conditions must be met:
• All resources must be fully employed. This
means that all resources are being fully used. If there
were unemployment of some resources, in which case
they would be sitting unused, the economy would
not be producing the maximum it can produce.
• All resources must be used efficiently.
Specifically, there must be productive efficiency.
The term ‘efficiency’ in a general sense means
that resources are being used in the best possible
way to avoid waste. (If they are not used in the
best possible way, we say there is ‘inefficiency’.)
Productive efficiency means that output is produced
by use of the fewest possible resources; alternatively,
we can say that output is produced at the lowest
possible cost. If output were not produced using the
fewest possible resources, the economy would be
‘wasting’ some resources.
The production possibilities curve (or frontier)
represents all combinations of the maximum amounts
of two goods that can be produced by an economy,
given its resources and technology, when there is full
employment of resources and productive efficiency.
All points on the curve known as production
possibilities.
What would happen if either of the two conditions
(full employment and productive efficiency) is not
met? Very simply, the economy will not produce at a
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point on the PPC; it will be somewhere inside the PPC,
such as at point F. At F, the economy is producing only
15 microwave ovens and 12 computers, indicating
that there is either unemployment of resources, or
productive inefficiency, or both. If this economy could
use its resources fully and efficiently, it could, for
example, move to point C and produce 26 microwave
ovens and 25 computers.
However, in the real world no economy is ever
likely to produce on its PPC.
An economy’s actual output, or the quantity of
output actually produced, is always at a point inside
the PPC, because in the real world all economies have
some unemployment of resources and some productive
inefficiency. The greater the unemployment or the
productive inefficiency, the further away is the point of
production from the PPC.
The production possibilities curve and
scarcity, choice and opportunity cost
The production possibilities model is very useful
for illustrating the concepts of scarcity, choice and
opportunity cost:
• The condition of scarcity does not allow the
economy to produce outside its PPC. With
its fixed quantity and quality of resources and
technology, the economy cannot move to any point
outside the PPC, such as G, because it does not have
enough resources (there is resource scarcity).
• The condition of scarcity forces the economy
to make a choice about what particular
combination of goods it wishes to produce.
Assuming it could achieve full employment and
productive efficiency, it must decide at which
particular point on the PPC it wishes to produce.
(a) Increasing opportunity costs
microwave ovens
computers
Figure 1.2 Production possibilities curve with increasing and constant opportunity costs
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(In the real world, the choice would involve a point
inside the PPC.)
• The condition of scarcity means that choices
involve opportunity costs. If the economy were
at any point on the curve, it would be impossible to
increase the quantity produced of one good without
decreasing the quantity produced of the other good.
In other words, when an economy increases its
production of one good, there must necessarily be
a sacrifice of some quantity of the other good; this
sacrifice is the opportunity cost.
Let’s consider the last point more carefully. Say the
economy is at point C, producing 26 microwave ovens
and 25 computers. Suppose now that consumers would
like to have more computers. It is impossible to produce
more computers without sacrificing production of some
microwave ovens. For example, a choice to produce 31
computers (a move from C to D) involves a decrease
in microwave oven production from 26 to 15 units,
or a sacrifice of 11 microwave ovens. The sacrifice of
11 microwave ovens is the opportunity cost of 6 extra
computers (increasing the number of computers from
25 to 31). Note that opportunity cost arises when the
economy is on the PPC (or more realistically, somewhere
close to the PPC). If the economy is at a point inside the
curve, it can increase production of both goods with no
sacrifice, hence no opportunity cost, simply by making
better use of its resources: reducing unemployment or
increasing productive efficiency.
The shape of the production
possibilities curve
In Figure 1.2(a) the PPC’s shape is similar to that of
Figure 1.1, while in Figure 1.2(b) it is a straight line.
When the PPC bends outward and to the right, as in
Figure 1.2(a), opportunity costs change as the economy
moves from one point on the PPC to another. In part (a),
(b) Constant opportunity costs
basketballs
volleyballs
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for each additional unit of computers that is produced,
the opportunity cost, consisting of microwave ovens
sacrificed, gets larger and larger as computer production
increases. This happens because of specialisation of
factors of production, which makes them not equally
suitable for the production of different goods and
services. As production switches from microwave
ovens to more computers, it is necessary to give up
increasingly more microwave ovens for each extra unit
of computers produced, because factors of production
suited to microwave oven production will be less suited
to computer production. By contrast, when the PPC is a
straight line (as in Figure 1.2(b)), opportunity costs are
constant (do not change) as the economy moves from
one point of the PPC to another. Constant opportunity
costs arise when the factors of production are equally
well suited to the production of both goods, such as
in the case of basketballs and volleyballs, which are
very similar to each other, therefore needing similarly
specialised factors of production to produce them. As
we can see in Figure 1.2(b), for each additional unit of
volleyballs produced, the opportunity cost, or sacrifice
of basketballs, does not change.
Test your understanding 1.5
1 Consider the production possibilities data
in Table 1.1 and Figure 1.1. If the economy
is initially at point A and moves to point B,
computer production will increase by 17 units.
(a) What is the opportunity cost of the increase
in computer production? (b) If the economy
moves from D to C, what will be the gain and
what will be its opportunity cost? (c) If it moves
from point C to B, what will be the gain and
what will be its opportunity cost?
2 Use the concept of opportunity cost to explain
why the following two statements have the
same meaning: (a) productive efficiency
means producing by use of the fewest possible
resources, and (b) productive efficiency means
producing at the lowest possible cost.
3 (a) Distinguish between output actually
produced and output on the PPC. (b) Why is
an economy’s actual output most likely to be
located somewhere inside its PPC?
4 Say an economy is initially at point F, producing
15 microwave ovens and 12 computers (Figure 1.1).
What would be the opportunity cost of moving
to a point on the production possibilities curve,
such as point C, where it would be producing
26 microwave ovens and 25 computers?
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1.2 Economics as a social science
The nature and method of economics
Economics as a social science
� Explain that economics is a social science.
The social sciences are academic disciplines that
study human society and social relationships. They
are concerned with discovering general principles
describing how societies function and are organised.
The social sciences include anthropology, economics,
political science, psychology, sociology and others.
Economics is a social science because it deals with
human society and behaviour, and particularly those
aspects concerned with how people organise their
activities and how they behave to satisfy their needs
and wants. It is a social science because its approach
to studying human society is based on the social
scientific method.
The social scientific method
� Outline the social scientific method.
As a social science, economics tries to explain in a
systematic way why economic events happen the way
they do, and attempts to predict economic events
likely to occur in the future. To accomplish all this,
economists use the social scientific method. This
is the same as the scientific method, which you may
already be familiar with through your studies of one
or more of the natural sciences (for example, biology,
chemistry, and physics). It is a method of investigation
used in all the social and natural sciences, allowing us
to acquire knowledge of the world around us.
The social scientific (or scientific) method consists
of the following steps:
Step 1: Make observations of the world
around us, and select an economic question
we want to answer. Let’s consider an example
from economics. We observe that people living in
the city of Olemoo buy different amounts of oranges
per week at different times in the year. We want to
answer the question: why are more oranges bought
in some weeks and fewer in others?
Step 2: Identify variables we think are
important to answer the question. A variable
is any measure that can take on different values,
such as temperature, or weight, or distance. In our
example the variables we choose to study are the
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quantity of oranges that residents of Olemoo buy
each week, and the price of oranges.
Step 3: Make a hypothesis about how
the variables are related to each other. A
hypothesis is an educated guess, usually indicating
a cause-and-effect relationship about an event.
Hypotheses are often stated as: if . . ., then . . .. Our
hypothesis is the following: if the price of oranges
increases, then the quantity of oranges Olemooans
want to buy each week will fall. Notice that this
hypothesis indicates a cause-and-effect relationship,
where price is the ‘cause’ and the quantity of
oranges is the ‘effect’. The hypothesis also involves
a prediction, because it claims that changes in the
price of oranges will lead to a particular change in
the quantity of oranges Olemooans buy.
Step 4: Make assumptions. An assumption is a
statement we suppose to be true for the purposes
of building our hypothesis. In our example we are
making two important assumptions. (a) We assume
that the price of oranges is the only variable that
influences the quantity of oranges Olemooans
want to buy, while all other variables that could
have influenced their buying choices do not play
a role. (b) We assume that the residents of Olemoo
Theory of knowledge
More on testing hypotheses and the scientific method
We have seen how hypotheses are tested using the
social scientific method. If the data fit the predictions
of a hypothesis, the hypothesis is accepted. However,
this does not make the hypothesis necessarily ‘true’ or
‘correct’. The only knowledge we have gained is that
according to the data used, the hypothesis is not false.
There is always a possibility that as testing methods are
improved and as new and possibly more accurate data are
used, a hypothesis that earlier had been accepted now is
rejected as false. Therefore, no matter how many times a
hypothesis is tested, we can never be sure that it is ‘true’.
But by the same logic, we can never be sure that
a hypothesis that is rejected is necessarily false. It is
possible that our hypothesis testing, maybe because of
poor data or poor testing methods, incorrectly rejected a
hypothesis. Testing of the same hypothesis with different
methods or data could show that the hypothesis had
been wrongly rejected.
If our results from hypothesis testing are subject to so
many uncertainties, how can economic knowledge about
the world develop and progress? Economists and other
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spend their money on oranges (and other things
they want) so that they will get the greatest possible
satisfaction from their purchases. We will examine
both these assumptions later in this section.
Step 5: Test the hypothesis to see if its
predictions fit with what actually happens
in the real world. To do this, we compare the
predictions of the hypothesis with real-world events,
based on real-world observations. Here, the methods
of economics differ from those of the natural
sciences. Whereas in the natural sciences it is often
(though not always) possible to perform experiments
to test hypotheses, in economics the possibilities for
experiments are very limited. Economists therefore
rely on a branch of statistics called econometrics
to test hypotheses. This involves collecting data
on the variables in the hypothesis, and examining
whether the data fit the relationships stated in the
hypothesis. In our example, we must collect data
on the quantity of oranges bought by Olemoo’s
residents during different weeks throughout the year,
and compare these quantities with different orange
prices at different times in the year. (Econometrics is
usually studied at university level, and is not part of
IB requirements.)
social and natural scientists work with hypotheses that
have been tested and not falsified (not rejected). While
the possibility exists that the hypotheses may be false,
they use these hypotheses on the assumption that they
are not false. As more and more testing is done, and as
unfalsified hypotheses accumulate, it becomes more and
more likely that they are not false (though we can never
be sure). This way, it is possible to accumulate knowledge
about the world, on the understanding, however, that this
knowledge is tentative and provisional; in other words, it
can never be proven to be correct or true.
Thinking points
• Is it possible to ever arrive at the truth of a statement
about the real world based on empirical testing?
• Even assuming that testing methods could be
perfected and data vastly improved, can there ever be
complete certainty about our knowledge of the social
(and natural) worlds?
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Step 6: Compare the predictions of the
hypothesis with real-world outcomes.
If the data do not fit the predictions of the
hypothesis, the hypothesis is rejected, and the
search for a new hypothesis could begin. In our
example, this would happen if we discovered that
as the price of oranges increases, the quantity
of oranges Olemooans want to buy each week
also increases. Clearly, this would go against
our hypothesis, and we would have to reject
the hypothesis as invalid. If, on the other hand,
the data fit the predictions, the hypothesis is
accepted. In our example, this would occur if our
data show that as the price of oranges increases,
Olemoo’s residents buy fewer oranges. We can
therefore conclude that according to the evidence,
our hypothesis is a valid one.
Economists as model builders
� Explain the process of model building in economics.
In economics, as in other social (and natural)
sciences, our efforts to gain knowledge about the
world involve the formulation of hypotheses,
theories, laws and models. The relationships between
these ideas are explored in the Theory of knowledge
feature on page 10. Here we focus on the role of
models.
Everyone is familiar with the idea of a model. As
children, many of us played with paper aeroplanes,
which are models of real aeroplanes. In chemistry
at school, we studied molecules and atoms, which
are models of what matter is made of. Models are
a simplified representation of something in the
real world, and are used a lot by scientists and
social scientists in their efforts to understand or
explain real-world situations. Models represent
only the important aspects of the real world being
investigated, ignoring unnecessary details, thereby
allowing scientists and social scientists to focus on
important relationships.
Whereas sciences like biology, chemistry
and physics offer the possibility to construct
three-dimensional models (as with molecules
and atoms), this cannot be done in the social
sciences, because these are concerned with human
society and social relationships. In economics,
models are often illustrated by use of diagrams
showing the relationships between important
variables. In more advanced economics, models
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are illustrated by use of mathematical equations.
(Note that both diagrams and mathematical
equations are used to represent models in natural
sciences, such as physics, as well.) To construct a
model, economists select particular variables and
make assumptions about how these are interrelated.
Different models represent different aspects of
the economic world. Some models may be better
than others in their ability to explain economic
phenomena.
Models are often closely related to theories, as
well as to laws. A theory tries to explain why certain
events happen and to make predictions; a law is a
concise statement of an event that is supposed to
have universal validity. Models are often built on
the basis of well-established theories or laws, in
which case they may illustrate, through diagrams or
mathematical equations, the important features of
the theory or law. When this happens, economists
use the terms ‘model’ and ‘theory’ interchangeably,
because in effect they refer to one and the same
thing. For example, in Chapter 7, we will use models
to illustrate the ideas contained in the theory
of firm behaviour. Later, in Chapter 9, different
models of the macroeconomy will be used to
illustrate alternative theories of income and output
determination.
However, models are not always representations
of theories. In some cases, economists use models
to isolate important aspects of the real world and
show connections between variables but without any
explanations as to why the variables are connected
in some particular way. In such cases, models are
purely descriptive; in other words, they describe a
situation, without explaining anything about it. For
example, the production possibilities model, which
we studied on page 5, is a simple model that is very
important because of its ability to describe scarcity,
choice and opportunity cost. The model describes the
basic problem of economics, which is that societies
are forced to make choices that involve sacrifices
because of the condition of scarcity. There is no theory
involved here.
Descriptive models that are not based on a theory
are in no way less important than models that
illustrate a theory. Both kinds of model are very
effective as tools used by economists to highlight and
understand important relationships and phenomena
in the economics world. In our study of economics, we
will encounter a variety of economic models and will
make extensive use of diagrams.
Chapter 1 The foundations of economics 9
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Theory of knowledge
Hypotheses, theories, laws and models
We have seen that a hypothesis is an educated guess
about a cause-and-effect relationship in a single event.
A theory is a more general explanation of a set of
interrelated events, usually (though not always) based on
several hypotheses that have been tested successfully
(in other words, they have not been rejected, based
on evidence; see the Theory of knowledge feature on
page 8). A theory is a generalisation about the real world
that attempts to organise complex and interrelated
events and present them in a systematic and coherent
way to explain why these events happen. Based on their
ability to systematically explain events, theories attempt
to make predictions.
A law, on the other hand, is a statement that
describes an event in a concise way, and is supposed to
have universal validity; in other words, to be valid at all
times and in all places. Laws are based on theories and
are known to be valid in the sense that they have been
successfully tested very many times. They are often
used in practical applications and in the development of
further theories because of their great predictive powers.
However, laws are much simpler than theories, and do
not try to explain events the way theories do.
Referring to the example of oranges (page 7), the
relationship between the price of oranges and the
quantity of oranges residents of Olemoo buy at each
price was a hypothesis. This kind of hypothesis has been
successfully tested a great many times for many different
goods, and the data support the presence in the real
world of such a relationship. However, this relationship
is not a theory, because it only shows how two variables
relate to each other, and does not explain anything about
why buyers behave the way they do when they make
decisions to buy something. To explain this relationship
in a general way, economists have developed ‘marginal
Test your understanding 1.6
1 Explain the social scientific method. What steps
does it involve?
2 Why is it important to compare the predictions
of a hypothesis with real-world outcomes?
3 How do models help economists in their work
as social scientists?
10 Introduction
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utility theory’ and ‘indifference curve analysis’ based on
a more complicated analysis involving more variables,
assumptions and interrelationships. These theories try
to answer the question why people behave in ways
that make the observed relationship between price and
quantity a valid one.
Yet, the simple relationship between the quantity of
a good that people want to buy and its price, while not
a theory, has the status of one of the most important
laws of economics, called the law of demand. This law
is a statement describing an event in a simple way. It
has great predictive powers and is used as a building
block for very many complex theories. We will study
the law of demand in detail in Chapter 2 and we will
use it repeatedly throughout this book in numerous
applications, and as a building block for many theories.
In your study of economics, you will encounter many
theories and some laws. Your study of both theories and
laws will make great use of economic models. Models,
as explained in the text, are sometimes used to illustrate
theories (or laws) and sometimes to describe the
connections between variables.
Thinking points
The relationships between hypotheses, theories, laws and
models described here apply generally to all the sciences
and social sciences based on the scientific method. Yet
they may differ between disciplines in the ways they are
used and interpreted. As you study economics, you may
want to think about the following.
• How are theories and laws used in economics as
compared with other disciplines? Do they play the
same role? Are they derived in the same ways? Do
they have the same meaning?
Two assumptions in economic model-building
Ceteris paribus
� Explain that economists must use the ceteris paribus
assumption when developing economic models.
When we try to understand the relationship between
two or more variables in the context of a hypothesis,
or economic theory or model, we must assume that
everything else, other than the variables we are
studying, does not change. We do this by use of the
ceteris paribus assumption:
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